Can bonds and equities withstand the tapering of quantitative easing? How far have real estate and emerging market valuations gone? Where are investors most vulnerable as they search
for yield in 2014?

Government bonds, such as UK gilts and US Treasuries, are overvalued given the finances of the two countries. When rates start to go up, it will have a big impact given the low absolute level of yields at present.

“Riskless assets” (Treasuries and cash) are at overvalued levels as a result of risk aversion and central bank intervention. In sharp contrast, almost none of the “riskier assets” seem overvalued. US equity market valuations are at peak levels because earnings are at peak levels as well, with P/E ratios just around historical averages. Also, credit spreads are tight because volatility and default rates are near historical lows. And unless Treasuries correct, low discount factors should support model valuations of riskier assets.

We see government bond markets as the most overvalued asset class, even with yields backing up since their trough last year. Within equity markets, our analysis suggests that some, such as the US, are moving into relatively rich territory, but are not seriously overvalued as long as the economic and corporate backdrop remains supportive. Certain currencies remain overvalued, notably the Australian dollar, and our portfolios are positioned accordingly.

Alan Brown, Senior adviser, Schroders

Developed government bonds on near-zero real yields continue to look very expensive by historic standards and may be the next bubble to burst. Meanwhile, equities that looked cheap in intrinsic terms, and very cheap in relative terms, are now more fairly valued after two years of buoyant returns. Reinvestment risk is growing. It is getting harder to find attractively priced assets.

Government bonds have been above long-term fair value for a while as yields have been kept at historic lows by the central bank liquidity injections. Safe haven yields have begun to rise and we expect more to come as the Federal Reserve eventually starts tapering. The transition from a liquidity-induced market towards more earnings-driven market may be bumpy. Emerging markets could suffer in the short term, even though there is potential for long-term growth.

Markets have built Fed tapering into bond prices, so yields are unlikely to retest lows, but it’s difficult to be bullish about the asset class. Even with ECB interest rates at record lows, core Eurozone bonds still don’t entice. Cash offers little compensation for investors seeking real return. Our growth outlook and near-zero policy rates still favour riskier assets. Defensive stock valuations look less appealing. As we navigate in relatively higher valuations, there is a risk from events that change perception and trigger negative market reactions.

Government bonds are the most overvalued asset class because of central banks’ quantitative easing. We expect QE to end in the US in 2014 but continue in Japan. This could cause bond yields to drift upwards to more normal levels for the growth and inflation outlook, affecting the valuation of all asset classes as the yield on “risk-free” assets becomes more attractive. Within equities, much good news is priced in, especially in the US, but equities are still preferred to government bonds.

Core government bonds – US, UK, Germany and Japan – are trading at levels not seen, broadly speaking, since the 18th century. No one expects this to last and 2014 increasingly seems the year in which yields will snap back. The Federal Reserve would like to reduce QE gradually, but the risk is that markets will go straight to the end-game. A rise in interest rates will not kill the recovery, but it is likely to cause delays.

Tim Ryan, Regional chief executive, AllianceBernstein

Since the crisis, money has flown out of equities to the perceived safer haven of government bonds in Europe and the US, leaving these bonds looking overvalued – with some arguing they now offer “return-free risks”. Investors nowadays need to think differently about which assets are risky and which are stabilising. Furthermore, we need to be aware of the dangerous crowding in some asset classes and, as such, plan for scenarios in which liquidity might dry up.

Clem Chambers, Chief executive, ADVFN

Bonds are, by QE definition, overvalued. If this were a free market, bonds would be much lower. At some point the dam of QE will burst and bonds will revert. Cracks in the dam may start appearing in 2014.

Pascal Blanqué, Chief investment officer, Amundi

The most overvalued assets are government bonds in major advanced economies. Some credit segments are also becoming expensive by historical standards. The global deleveraging process in the major advanced economies is exerting deflationary pressure and central banks are trapped in non-conventional policies, with no quick normalisation likely. While the rise in bond yields remains gradual and corresponds to stronger growth, the “search for yield” theme may prevail, ultimately benefiting risk assets and leading to a gradual rotation from spread products to equities.

HIGH-YIELD BONDS

Lance Uggla, Chief executive, Markit

High-yield debt in North America and Europe could be considered overvalued. Issuance in CCC debt has soared and yields have plummeted. QE has suppressed yields in investment-grade debt, “forcing” investors to go down the ratings scale in search of yield. Bulls would point towards robust corporate balance sheets and low default rates to support current valuations. But when QE begins to taper – as is expected – the prospect of less liquidity could trigger a sell-off in high-yield debt.

The search for yield during this prolonged period of very low interest rates is leading to distortions in asset pricing, where income is the dominant component of return. This is particularly notable in fixed-income markets where, in absolute terms, yields on corporate and high-yield (junk) bonds are at historically low levels. Demand for such paper has been running at record levels and investors are potentially ignoring the risks. This has the potential to create the next serious dislocation in markets.

QE has led to an unseemly stretch for yield in the unsecured below investment-grade corporate bond market. This has led to a sharp decline in underwriting standards and a deep contraction in absolute yield. Moreover, the indiscriminate buying of high-yield ETFs leaves this market particularly vulnerable to a change in sentiment as the junk market is not nearly as deep as the strong issuance volumes in Europe and the US suggest. Look for floating-rate leveraged loans and secured debt to outperform.

Jonathan Little, Partner, Northill Capital

Corporate bonds. It would be tempting to say equities because it’s hard to see much upside from here but bonds worry me more. Spreads and implied default rates are very low and, at this stage of the interest rate cycle, I just can’t see that investors are being remotely rewarded for the risks they are taking.

I am not sure if this would impact within the next 12 months – markets are notorious for overshooting before correcting to normality – but the one thing that is clear is that interest rates are likely to rise from these super low levels, which will have a negative impact on bonds and credit instruments.

I am concerned about the debt markets and their reaction to the Fed tapering. When mid-to-low single B credits can get 10-year funding in the 6’s it feels like there is nowhere to go from here but wider. We are advising all of our issuers to get into the markets if they need funding and take advantage of the historically attractive coupons before rates creep up.

Lionel Aeschlimann, Managing partner and head of asset management, Mirabaud

Fixed income: rates are still low and despite the tapering hiccups of the summer, investors in plain vanilla long-dated government bonds are due to get mediocre returns and face a challenging environment when yields go up again. Investors are still heavily invested in classic fixed-income instruments and need to prepare for the “bond turn”. Long-term Swiss fixed-income indices, among others, will finish 2013 in negative territory and this will be a wake-up call for many investors.

Fixed income will remain penalised by gradually increasing interest rates so, in this context, equities will continue to be the preferred asset as its relative value remains attractive for investors – a trend which we expect to be continued and even reinforced in 2014.

EQUITIES

David Blumer, Head of Emea, BlackRock

Most assets are no longer bargains in valuation terms. Fixed income has long been expensive versus its own history, but many equity markets are catching up. Within fixed income, the greatest risks appear to be in medium-term duration bonds, and we tend to favour credit sectors across the world in our search for yield. For equities, it is complicated. Most investors believe European equities currently are better value than US stocks, and the verdict is split on Japan.

Asset classes such as safe-haven sovereign bonds, REITS or commodities were already overvalued in early 2013. Equities are also expensive by historic standards. Continued benign consumer price inflation and central bank liquidity provision will fuel asset price inflation, driving more risky asset classes such as high-yield corporate bonds or equities. For 2014, equity valuation multiples will increase further, including continued rotation from bonds to equities, a pickup of M&A and buyback activity. However, the risk of larger corrections is obviously increasing.

Pascal Duval, Chief executive Emea, Russell Investments

US equities look pricey, Japan and Europe have slightly better value and emerging market equities are the value play. US Treasuries are not as expensive as a year ago but still offer poor medium-term value. Credit offers little more than coupon clipping. The implication is that investors more than ever need multi-asset diversification and active top-down portfolio management. They need to focus on squeezing every basis point out of their portfolios. The year 2014 will not be a set-and-forget year.

It’s hard to know the right price of any asset with the amount of worldwide quantitative easing that has occurred. US QE alone is estimated at $85 billion a month and that is a big parachute for dollar-denominated assets. The equity market could see the biggest downturn with tapering that has to take place in 2014 – Janet Yellen intimated as much in her Senate Panel. Surely we can’t keep seeing all-time highs but, then again, that’s why I’m in foreign exchange!

Michael John Lytle, Chief development officer, Source

Two potentially overvalued asset classes are European credit and US equity. Both are priced for a world in better shape than we are today. However, we are unlikely to see a crash. A correction in US (and European) equities seems inevitable as it is unlikely that markets will trade sideways for long enough to allow company performance to catch up with valuations.

Over the past year, developed market equities have rotated from quality growth into value – driven partly by southern Europe where optimism reigns: the scope for disappointment here is high. In emerging market equities, the quality-growth trade has persisted, driving valuations in reliable areas such as consumer staples and healthcare to stratospheric levels. In aggregate the asset class trades at attractive valuations masking bifurcation, with resources/ basics/energy on all-time-low multiples. While investible, the balance of emerging markets exposures should be considered carefully.

The current environment accommodates very little overvaluing. Company stocks in major growth areas, notably emerging technology and social media, continue to receive valuations that make little sense on pure fundamentals. The large unknown is how these assets will be leveraged globally, especially when considering the need to comply with regulations that scrutinise cross-border information security. It is hard to envisage where or how some of these companies will generate positive net income to maintain and enhance their value.

These days there is a “bubble” in the prediction of “bubbles”. At risk of joining the bubble brigade, I would point to Bitcoin followed by developed market bonds, which will remain expensive while governments continue with the current regime of financial repression. The price of farmland has also risen too fast to be related to fundamentals.

Mark Pumfrey, Head of Emea, Liquidnet

Commodities in general, and there will continue to be limited upside in investing in bonds following a difficult year for this asset class in 2013. Risk assets such as equities will continue to move up as long as inflation remains benign, which seems likely to remain the case in major economies across the world in 2014.